Fed: Avoiding the risks of stargazing

Gazing stars is dangerous when you walk around because you might hit an object standing in your way. Better watch where you’re heading than look at the stars for direction is the message from Fed chairman Powell in Jackson Hole last week. His intervention was all about stars:

“At the Fed and elsewhere, analysts talk about these values so often that they have acquired shorthand names… u* (pronounced “u star”) is the natural rate of unemployment, r* (“r star”) is the neutral real rate of interest, and π* (“pi star”) is the inflation objective. According to the conventional thinking, policymakers should navigate by these stars. In that sense, they are very much akin to celestial stars.”

This makes sense were it not that estimates of the natural rate of employment and the neutral interest rate are highly uncertain. Interestingly, this issue had already been covered at Jackson Hole back in 2003. Though the analytical sophistication has increased, the challenge of determining the exact location of the stars remains huge. The wide range of estimates of the neutral rate of interest limits its relevance for decision making, including for investors. Potential growth (and hence output gap) estimates vary significantly depending on the source and are subject to considerable revisions. This is less of an issue with ‘pi star’ because the inflation objective is chosen. However, as emphasized by Powell “in the run-up to the past two recessions, destabilizing excesses appeared mainly in financial markets rather than in inflation.” So when inflation expectations are well anchored, the focus should shift from inflation to other signs of overheating (although this didn’t yet show up in Fed communication).

Financial markets considered Powell’s speech as rather dovish and there are several reasons for that. The chairman’s praise for the Fed’s gradualism under Greenspan suggests he’s very much inspired by this approach:

“The FOMC thus avoided… overemphasizing imprecise estimates of the stars. Under Chairman Greenspan’s leadership, the Committee converged on a risk-management strategy that can be distilled into a simple request: Let’s wait one more meeting; if there are clearer signs of inflation, we will commence tightening”.

Moreover, ever better anchored inflation expectations implied “a smaller risk that an inflation uptick under Greenspan’s “wait and see” approach would become a significant problem”, a phrase which is reminiscent of the recent emphasis on the symmetric nature of the Fed’s inflation objective. To avoid any doubt, Powell then adds:

“Given what the economy has shown us over the past 15 years, the need for the sort of risk-management approach that originated in the new-economy era is clearer than ever before.”

In plain English, the Fed’s approach can be described as gradual, cautious, data- dependent and pragmatic. The description of the current environment also brings a dovish bias:

“Inflation has become much less responsive to changes in resource utilization… While inflation has recently moved up near 2 percent, we have seen no clear sign of an acceleration above 2 percent, and there does not seem to be an elevated risk of overheating.”

Finally the warning that “I am confident that the FOMC would resolutely “do whatever it takes” should inflation expectations drift materially up or down” didn’t impress markets. Investors seem as confident as the Fed that inflation will remain well-behaved.